Sennholz The Underground Economy

The Underground Economy

Hans F. Sennholz

Copyright © 1984 by the Ludwig von Mises Institute.

Online edition copyright © 2003 by the Ludwig von Mises Institute.

Table of Contents
Work in the Underground	3
Hiding From Tax Collectors	5
Circumventing Regulations and Licensing Requirements	9
Reaping Transfer Benefits While Working in the Underground	15
Estimating Underground Employment	21
About the Author	27

Work in the Underground

There is a bustling and shadowy world where jobs, services, and business transactions are conducted by word of mouth and paid for in cash to avoid scrutiny by government officials. It is called the “underground economy,” which is as old as government itself. It springs from human nature that makes man choose between given alternatives. Facing the agents of government and their exactions, man will weigh the alternatives and may choose to go “underground.”

In the ancient world, most rulers were tyrants who commanded the laws and lorded over their subjects. They set just and “fair” prices for labor and commodities, and enforced them with arbitrary power and terror. The people either suffered degrading submission or sought escape in countless ways and directions. Many went “underground” or moved elsewhere in search of better conditions. They reacted to edicts of the Egyptian dynasties and the Roman emperors, as they did later to the mandates of their Medieval feudal lords. Immutable in his nature, man is forever acting on and reacting to the world around him.

In our era, man has again become a subject under the watchful eye of government. Guided by ancient notions and prejudices he depends on his rulers for mandates and directives. When government intervention fails to satisfy him, or even works evil, he is slow to relinquish his notions and prejudices. He may cling to them with tenacity and perseverance, but may seek to avoid the ill effects through circumvention, evasion, and escape. He may find his way to the “black market,” where economic transactions take place in violation of price control and ration laws. Or he may descend to the “underground” where political edicts are ignored and exactions avoided through word-of- mouth dealings and cash transactions.

The underground economy must be distinguished clearly and unmistakably from the criminal activities of the underworld. Government

4	The Underground Economy

officials and agents are ever eager to lump both together, the criminals and their organization with the producers in the underground. Both groups are knowingly violating laws and regulations and defying political authority.

But they differ radically in the role they play in society. The underworld comprises criminals who are committing acts of bribery, fraud, and racketeering, and willfully inflicting wrongs on society. The underground economy involves otherwise law-abiding citizens who are seeking refuge from the wrongs inflicted on them by government. They are employers and employees who are rendering valuable services without a license or inspection sticker, or failing to report their productive activities to the political authorities.

Underground activities can be grouped into four main catego ries:

1.Economic activity yielding income that is not reported to the tax authorities.

2.Economic production that violates one or several other mandates, such as compulsory government licensing and rate making, inspection and label laws, labor laws, government regula tions of agriculture, export and import controls, government control over money and banking, governmental control of energy production and distribution, and countless others. Violators may or may not evade taxes, but they all work illegally, hiding from swarms of government inspectors.

3.Productive activity by transfer beneficiaries who draw Social Security benefits or receive public assistance. Their freedom to work is severely restricted.

4.Productive activity by illegal aliens without residence status. They may pay income taxes and other taxes, but must remain underground for fear of deportation.

Hans F. Sennholz

5

Hiding From Tax Collectors

A tax is a compulsory payment of income or wealth to the government to defray the expenses incurred in performing services and to finance income and wealth transfer to tax consumers. It impairs the economic conditions of producers and thereby reduces their ability to consume and invest. By reducing the returns from productive effort it lowers the marginal utility of such effort, and raises that of leisure. It makes many taxpayers prefer leisure to work.

It is difficult to estimate the magnitude of this shift to leisure in recent years of rising taxation. Many millions of elderly people have gone “into retirement’ consuming their savings and idling their days away searching for fun and play. They have flocked to resort and retirement centers, especially in Florida, Arizona, California, and Hawaii, where they support thriving entertainment and amusement industries and kindle unbridled real estate booms. In reaction to ever-rising levels of taxation, younger workers may choose to work fewer hours and take longer vacations. Many may seek to reduce the number of weekly hours from forty to thirty-five, or even to thirty. Others may seek benefits that are tax-exempt, such as expense accounts, stock purchase options, club memberships, health care and insurance benefits, and countless other gratuities. They all are seeking escape and shelter from the tax collector.

In recent years millions of law-abiding American workers escaped by illegal methods; they joined the underground economy. High tax rates, soaring inflation, and a growing distrust of government led them to take this desperate step. No one can know with certainty just how many Americans actually participate in the underground. Yet it is common knowledge that vast amounts of goods and services are produced without being reported to government authorities, that the unemployment rate is a lot lower than the official rates of the Labor Department, and that the actual savings rate is much higher that commonly thought.

6	The Underground Economy

Taxation lowers the marginal utility of productive labor and reduces economic output; the underground economy raises the marginal utility of labor and increases economic output. But it does so at the risk of discovery by government officials and agents and potential retribution by the courts and penal institutions. The risk is directly proportional to the productivity of the underground worker. It is minimal for a common laborer who is earning a few dollars working “off the books” over weekends. His

income-tax return may not even warrant an audit by IRS agents. But the weekend entrepreneur who may earn thousands of dollars of profits is a moving target for auditors and, when found to labor in the underground economy, a readymade object of fines and imprisonment. It is easy to foresee the wrath of a federal judge and the cruel punishment he is likely to mete out to a businessman who evaded a million dollars in taxes.

The different degrees of risk of discovery and government retribution may explain the different intensities of underground activity. Millions upon millions of factory workers, painters, electricians, plumbers, cab drivers, farmers, and others whose risk exposure is minimal, are engaged in legal activities but fail to report part or all of their income to avoid paying taxes. Thousands of doctors, lawyers, accountants, contractors, restaurateurs, and small manufacturers are working “off the books,” trying to conceal income and evade tax exactions. But it is unlikely that many large entrepreneurs or their corporations are engaged in work on the side. They are rather visible not only to the IRS and its army of auditors and investigators, but also to many envious and resentful employees who eagerly report all irregularities to the authorities. It is difficult to imagine, therefore, General Motors or U.S. Steel engaging in subterranean activity.

There is little room for income tax evasion and underground activity where employers are forced to withhold taxes from wage and salary payments. Approximately two-thirds of federal individual income tax revenue is withheld by employers and transmitted directly to the U.S. Treasury. The employees never take possession of this part of income,

Hans F. Sennholz

7

which thus is kept out of reach for tax evasion. And employers are rarely tempted to hold on to the withholdings because they are not employer property. Yet the withholding of taxes is enlisting ever more workers in the underground. While it may reduce their tax conciousness, it creates a visible difference between the after-tax income and untaxed underground income. With rising tax withholdings this difference tends to grow, which may tempt more and more workers to forego taxable employment and descend to the underground. A master electrician who may suffer the withholding of 30 to 40 percent of his earned income may substantially raise his net income and improve his level of living by working independently and “off the books.”

The underground economy is thriving wherever, in the judge ment of taxpayers, the government exactions are exorbitant and unjust. It shuns written receipts, bank accounts, and other kinds of evidence that might reveal the activity. It makes a mockery of the popular forecast that the U.S. is headed toward a cashless society fueled by credit cards and electronic bank transfers. On the contrary, the underground, which is thriving on cash, is pointing towards a “cash only” economy where individuals shun all bank deposits. After all, the IRS, which has ready access to all bank records, usually begins its audits with bank deposit tests, and proceeds on the assumption that bank deposits are taxable income. It is quick to levy income taxes on all individual deposits, to impose fines and charge interest — unless the taxpayer can prove convincingly that his deposits were loans, transfers, or other “legitimate” receipts.

In the early years of federal income taxation when the rates were relatively low, it worked rather well for the U.S. Treasury. A high degree of taxpayer compliance characterized the American system. But rising tax exactions, together with soaring rates of inflation, caused public attitude toward tax evasion to change notably. The interaction between inflation and the progressive federal income tax system gradually weakened taxpayer compliance and encouraged underground activity. Inflation raises

8	The Underground Economy

nominal incomes and thereby pushes taxpayers into higher marginal tax brackets.

Since 1965 the marginal tax rate for a family of four earning the median income has risen from 17 to 24 percent in 1980.1 By now it is probably approaching 30 percent although real income is declining steadily. For double-median incomes it rose from 26 percent to 43 percent and now probably stands at 50 percent despite the 1981 tax rate reduction. To avoid or limit the decline in levels of living many taxpayers partly or completely descended to the underground where the effective tax rate is zero.

In the coming years of raging inflation that is bound to follow the colossal budget deficits, the interaction between inflation and taxation may doom the regulated and taxed economy, but undoubtedly will fortify the underground economy.

1 Barry Molefsky, “America’s Underground Economy” in Studies in Taxation, Public Finance and Related Subjects — A Compendium, Fund for Public Policy Research, Washington, D.C. 1982, p. 303.

Hans F. Sennholz

9

Circumventing Regulations and Licensing Requirements

Progressive federal and state taxation, in conjunction with soaring rates of inflation, provide an important motive power for underground economic activity. But the mainspring of the underground is yet more substantial and reputable than tax evasion. It is the inalienable right to life and property, which comprises the right to sustain both life and property through honest work. It is a basic right that precedes and supersedes all rules and regulations that would deny it. It takes precedence over minimum wage laws, license restrictions, union rules, and many other mandates that are denying the right to work.

There is no doubt that the underground economy is essentially an employment phenomenon. Where government causes disemployment the underground offers ample opportunities for employment. It offers jobs to the officially unemployable. It does so although it is besieged and harassed by government officials and their spokesmen in the media. It functions admirably although it is handicapped by a legal system that not only denies protection to its contract parties, but also threatens to fine and imprison them.

Minimum wage laws are nothing more than government orders to workers that they must not work for less than the stated minimum, and to employers that the y must pay the minimum, or not employ at all. But such mandates may deny millions of workers the right to work, which is synonymous with the basic right to sustain their lives through their own efforts. What is a worker to do who lacks the training and experience to earn the mandated minimum? If he is young and healthy he may join the armed forces. If he is intelligent and industrious he may seek the training that may permit him to earn the minimum. But if he is short any one of these attributes the minimum mandates condemn him to an empty life on charity and public assistance. The underground economy offers to suspend his life sentence and promises new hope and opportunity.

10	The Underground Economy

Many Americans enter the labor market via the underground. As young children they may earn their pocket money through odd chores that make them think, and teach them to be attentive, industrious, and confident.

Many parents are convinced that children should labor to be healthy and happy. But if they should work they probably violate some childlabor law. And if they should neglect to file an income tax return and fail to pay the levies, the children are actually working in the underground. Surely, there is a minimum amount that is exempt from income taxation. But the self-employment tax, which provides funds for Social Security and Medicare benefits, is levied on annual incomes of $400 or more, or just $1.13 per day. Many high school and college students are earning more than this.

In a climate of economic stagnation and decline the underground economy serves a useful economic and social function. It provides jobs to millions of willing workers, affords opportunities for learning and training, and teaches the importance of individua l initiative. It constitutes an important safety valve that relieves discontent and tension in a world wracked by political disruptions.

During the 1960s and 1970s, the U.S. Government, in cooperation with the state governments, destroyed millions of jobs. It forcibly raised the cost of labor through sizeable boosts in Social Security levies, unemployment taxes, Workman’s Compensation expenses, Occupational Safety and Health Act expenses, and many other production costs. The mandated raises inevitably reduced the demand for labor and added millions of workers to the unemployment rolls. The boosts also reduced the takehome pay of the remaining workers as market adjustments shifted the new costs to the workers themselves. Both effects, the rising unemployment and falling net wages, provided powerful stimuli to off- the-books employment.

The underground economy offers a new way of life that is very attractive to many young people. As the primary victims of stagna tion and